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Microsoft Walks from Yahoo Deal; Ball’s In Your Court, Jerry

But while I am truly surprised, I believe Steve Ballmer made the right call. I’ve said from the beginning that this deal was too big and too risky–I called it a potential merger from hell several times around the office and on TV–especially given the cultural differences between the two companies and the fact that Microsoft had never before pulled off an acquisition of this size.

Now that the tech industry’s biggest soap opera appears to have reached its dramatic conclusion, there are two big questions to answer:

1. Why did Ballmer and the Microsoft board pull a 180 and change their mind?

There’s got to be more to this story. Some people will wonder why Microsoft did not come back with a slightly higher offer, in the $34 to $35 range, which could have sealed the deal.

Something happened during this process that gave Microsoft the willies. Maybe it was the strong negative reaction from their employees that caught management off guard. Or maybe it was Yahoo’s determination to not break. Or maybe Ballmer underestimated the greed and toughness of some major shareholders.

To me, the behavour of the reluctant shareholders is just as surprising as Ballmer’s retreat. Reports have said that some big Yahoo investors such as Legg Mason were holding out for $34 or $35 a share. Given that Microsoft was willing to offer $33 a share, those shareholders will probably live to regret that position.

But while Ballmer ultimately did the right thing for his employees and shareholders, I believe his reputation is going to take a hit in the short term. This was Ballmer’s big first play as CEO of Microsoft and it just looks a bit odd for him to reverse course on such an enormous strategic move.

Now, Microsoft needs to figure out other ways “scale” and go after Google in the online advertising market. Maybe Microsoft will try to cut a deal with AOL or MySpace? My colleague Rob Hof believes that Microsoft might even “return with another offer down the road after things settle down.” I’m a bit more skeptical about that option because a more beaten-down Yahoo increases the chance of attracting another bidder.

2. What is Yahoo’s next move?

While I admire Yahoo’s toughness and determination to fight off the giant from Redmond, Jerry Yang & Co. have a lot of explaining to do. They just turned down a very handsome offer for their company. Many shareholders are going to be pissed and sell off the stock–while others are likley to launch a raft of lawsuits against Yahoo. My hunch is Yahoo plummets to the low $20s tomorrow morning. (It was around $19 before Microsoft made its $31 offer.)

The only reason it won’t fall further is because Yahoo keeps threatening to outsource part of its search traffic to Google. That could provide a short-term financial boost to Yahoo but it’s a losing long-term strategy as their share of search traffic would continue to decline, and it might even accelerate after such an arrangement. It also may never amount to much because regulators are likely to prevent the companies from cutting a substantial deal.

It will be interesting to see if Yahoo continues its merger talks with AOL, News Corp. or other partners. My hunch is that while they might, nothing is likely to come from it. For Yahoo, the merger talks seemed like more of a manufactured diversion or knee-jerk reaction than a well-considered move of true strategic intent.

So if Yahoo can’t or doesn’t pursue a significant deal with Google, and it doesn’t merge with another company, that still leaves the $44 billion question: What is Jerry Yang & Co. going to do to give Yahoo a better shot at remaining competitive ande lift its slumping stock?

Ball’s in your court, Jerry. Sometimes it’s dangerous to get what you wish for. Good luck.